Curmi & Partners

High disappointment risk due to high market complacency

By Matthias Busuttil

The strong rally in financial markets since the news broke out in November 2020 that a vaccine has been found, gained further momentum in the first few weeks of the year. Equity markets continued to move higher as safe-haven assets, such as government bonds, fell out of favour. This movement across markets shows a higher conviction by market participants that global economies finally have a fighting chance of getting rid of the virus and that economies are set to rebound strongly.

Underpinning these expectations was the assumption that the inoculations count reaches a critical size by the end of the second quarter in advanced economies. This would pave the way for health authorities and governments to lift containment measures and allow economic activity to pick up speed. Following the economic contraction of 3.5% in the US and the expected contraction of 10.6% and 7.2% in the UK and the Euro Area in 2020, consensus forecasts point to an economic expansion in 2021 of 4.1% in US, 4.5% in the UK and 4.3% in the Euro Area.

This in turn led to expectations of higher corporate earnings on the back of the improving prospects for business conditions and the return in demand and spending. At the same time, central banks remain highly committed to keep rates low to support the economic recovery through easy financing conditions. These two factors combined has resulted in increased risk-taking by investors which therefore led to higher valuations across equity markets.

However, the market seems to be growing increasingly insensitive to the real economic, political and health risks which continue to weigh on the global economic outlook. The increasing dislocation between asset valuations and the current economic reality makes higher exposure to risky assets look increasingly uncomfortable at current levels given the vulnerability of market sentiment to potential disappointment. Fulfilling these optimistic expectations is a tall order which highly depends on a successful vaccine rollout and a recovery in labour markets. On both fronts, recent data has been a cause of concern for policymakers.

Vaccine programs across major economies have so far achieved very low vaccination rates than originally expected. A variety of factors have resulted in these low rates ranging from supply shortages, logistical problems, and the lack of willingness by the public to take the vaccine. Labour markets continue to see lay-offs, mainly in the Euro Area and the UK, whilst the recovery in employment levels in the US came to a grinding halt, given the round of restrictive measures which slowed down activity in recent months.

What we need is continued fiscal support to protect economic players combined with strong political stewardship in a time when managing the high fiscal deficits requires striking the right balance between quelling short-term risks but also investing in long term economic productivity.

Moreover, a high degree of monetary support remains key for the time being, despite the likely rise in inflation rates in the near term, for three main reasons. The first is to ensure that real borrowing costs remain low to allow for the gradual normalization of the high public and private debt levels whilst economies recover. Secondly, a structural improvement in core inflation needs to be achieved through higher levels of employment and the closing of output gaps before monetary policy is tightened. Thirdly, central bank intervention remains critical to safeguard against shocks or distortions in financial markets.

The recent comments by the Fed chairman Jerome Powell shows a high sensitivity to these complex problems saying that a “patiently accommodative monetary policy that embraces the lessons of the past” is required to tackle these issues. This stance is shared by ECB president Christine Lagarde reiterating several times, at the most recent monetary policy press conference, the need to maintain easy financing conditions throughout.

There are reasons to remain optimistic and, given the current market conditions, investors could continue to rely on the expectations of an eventual return in economic growth and prosperity, whilst policymakers support the transition. However, clear risks remain that may threaten the positive outlook. Investors should remain alert to the higher vulnerability brought about by complacent financial markets.

The information presented in this commentary is solely provided for informational purposes and is not to be interpreted as investment advice, or to be used or considered as an offer or a solicitation to sell/buy or subscribe for any financial instruments, nor to constitute any advice or recommendation with respect to such financial instruments. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.